Reading Financial Statements & Valuation
P/E ratios, EPS, and why earnings can lie when cash flow usually can't.
The Three Statements, in Plain English
The income statement shows whether the company made a profit over a period (revenue minus expenses = net income).
The balance sheet is a snapshot of what the company owns (assets) versus what it owes (liabilities) at a single point in time.
The cash flow statement tracks actual cash moving in and out — separate from the income statement because accounting profit and cash are not the same thing.
Key Ratios
A handful of ratios cover most day-to-day valuation questions:
- EPS (Earnings Per Share) = Net Income ÷ Shares Outstanding — profit attributable to one share.
- P/E (Price-to-Earnings) = Share Price ÷ EPS — how many years of current profit you're paying for.
- P/B (Price-to-Book) = Share Price ÷ Book Value per Share — useful for asset-heavy businesses like banks.
- Debt/Equity = Total Debt ÷ Shareholder Equity — how leveraged the company is.
- Free Cash Flow = Operating Cash Flow − Capital Expenditures — cash left over after running and maintaining the business.
Rare but important
Net income relies on accrual accounting — revenue can be booked before cash is collected, and expenses can be smoothed or deferred through legitimate but flexible accounting judgment calls. Operating cash flow is closer to "cash that physically showed up." A useful gut-check: compare net income to operating cash flow over several years. If a company consistently reports healthy profits but operating cash flow is flat, negative, or far below net income, that persistent gap is one of the classic early warning signs seen in accounting scandals like Enron. It doesn't prove fraud, but it's always worth investigating.
Worked Example
Problem: Company A trades at $40 with EPS of $2 (P/E of 20). Company B trades at $20, also with EPS of $2 (P/E of 10). On P/E alone, B looks half the price of A. What key piece of information is missing, and how would you factor it in?
- P/E by itself says nothing about growth. A better tool here is the PEG ratio = P/E ÷ annual earnings growth rate.
- Suppose Company A is growing earnings 30% per year, while Company B is only growing 2% per year.
- Company A's PEG = 20 ÷ 30 = 0.67. Company B's PEG = 10 ÷ 2 = 5.0.
- Despite the "expensive-looking" P/E of 20, Company A is actually far cheaper relative to its growth than Company B — a PEG below 1 is often considered attractively priced, while a PEG of 5 suggests the stock is pricing in very little growth at a rich multiple.
- Lesson: never compare P/E ratios across companies without also considering growth rate, debt load, and cash flow quality.